Monday Morning Outlook

At Dow 14,000, Don't Fight the Uptrend

Why moves above round-number levels haven't always been cause for celebration

by 2/2/2013 10:25:00 AM
Stocks quoted in this article:

A Fed announcement, January's jobs report, and more multi-year highs for stocks ... while none of these events were shocking, they certainly kept investors engaged. The Dow waited until Friday to overtake 14,000, but does this mean smooth sailing ahead, or a temporary stopping point? While Rocky White looks at the historical implications of this millennium mark, Todd Salamone examines the present sentiment landscape, including reasons why this rally likely has more fuel in the tank.

  • Why a low VIX could be a good thing
  • 2 sentiment risks to the bullish case
  • The historical significance behind Dow 14,000

Finally, we close with a preview of the major economic and earnings events for the week ahead, plus a featured sector to watch.

Notes from the Trading Desk: How Low Can the VIX Go?
By Todd Salamone, Senior V.P. of Research

"In the first quarter of 2012, there were several periods in which the SPX went sideways for a week or two, but the sideways action was resolved with an advance to new high, followed by a very mild pullback that presented a buying opportunity. Overall, the SPX rallied at a few points here and there amid low volatility, which appears to be the case at present."
-Monday Morning Outlook, January 26, 2013

"...there are plenty of warning signs that show why the rally could be due for a pause. Contrarians say low short interest levels, combined with a low VIX and overly bullish investor sentiment indicate the market could be due for at least a short-term turn."
-The Wall Street Journal Morning MarketBeat, January 29, 2013

"'On paper it might look like a good idea to add cheap protection,' Marais, who helps oversee $327 billion at Schroders as head of multi-asset investments and portfolio solutions, said in a phone interview yesterday."
-Bloomberg email, January 22, 2013

The first quarter of 2013 continues to follow the low-volatility upward trajectory of 2012's first quarter, which we discussed in depth last week. As of Thursday, the S&P 500 Index (SPX - 1,513.17) found itself sitting right around the previous Friday's close (at 1,498.11 versus 1,502.96). But on Friday, the broad-market index powered above 1,500 on the strength of a well-received employment report, and the CBOE Market Volatility Index (VIX - 12.90) -- which had ticked nearly two points higher in the second half of January -- gapped lower after this important economic data was released.

In addition to those indices mentioned last week, another major benchmark took on a huge, psychologically significant round number on the first trading day of February, as the Dow Jones Industrial Average (DJIA - 14,009.79) began its assault on 14,000. Including Friday's trading, there are only three months in the DJIA's history that 14,000 has been touched. But per the chart below, there has never been a monthly close above this millennium mark. Moreover, the failure at 14,000 in October 2007 preceded a roughly 50% haircut into early 2009. (Be sure to read page two for Rocky White's commentary on the DJIA and its historical tendencies when challenging millennium levels.)

 Monthly Chart of Dow Jones Industrial Average since April 2001

Meanwhile, "off the chart" call buying on the VIX continues, on the heels of record call buying last quarter. I found the excerpts in The Wall Street Journal and Bloomberg interesting in the context of the chart below, which shows huge call buying amid a powerful rally in the market. While some commentators have credited this rally to the return of the retail player, we would argue that cheap portfolio protection is encouraging fund managers who have missed the rally to move off the sidelines.

So, in contrast to some folks who have cited a low VIX as reason to expect a decline, a low VIX may be driving professional traders into the market. Another scenario is that with some benchmarks hitting record highs, fund managers are being forced into the market, and the record VIX call buying reflects apprehension about doing so at current levels. Regardless of their motivations, to the extent that more portfolios are crash protected, there is less selling pressure on pullbacks, as hedged professionals are less apt to panic than unhedged money.

Amid the VIX call buying, VIX call open interest is on pace to achieve record levels once again. Active participation among professional traders is encouraging, but something to be on guard for is their equity exposure growing to the point that they can no longer support the market. If VIX call buying suddenly disappears, it would be a red flag, especially if the market's momentum appears to slow. For now, this does not appear to be the case, with the SPX hitting multi-year highs, and VIX call buying still extremely healthy.

VIX 20-day call and put volume since 2011

How low can the VIX go? One area we will be watching, if the VIX continues to decline, is the area between 11.36 and 11.61. These levels represent, respectively, half the Dec. 28, 2012 closing and intraday peaks at 22.72 and 23.23. In previous commentaries, we have mentioned the peculiar action in the VIX in terms of bottoming at half highs or peaking at levels 50% or 100% above previous lows.

While the market's upward momentum continues -- with potential support from retail players chasing the market higher, short-covering activity, or funds leveraging up -- we see a couple of risks from a sentiment perspective.

First, this past week, the National Association of Active Investment Managers (NAAIM) reported a multi-year high in equity exposure, with the reading above 100 suggesting this group is fully invested. A reading of 200 would suggest a leveraged long position.

Also, according to Investor's Intelligence (a survey of advisors), the percentage of bears is approaching 20%. As you can see on the second chart below, when the bearish percentage is this low, and the SPX is approaching round numbers, the market has been vulnerable to setbacks.

Our thought right now is to not fight the market's momentum, since professionals are hedged. But if the strong technical backdrop begins to weaken and you see signs of a shift in sentiment from growing optimism to growing pessimism, that would be the point at which to re-evaluate bullish positions.

NAAIM Sentiment since March 2009

S&P  500 Index with Bulls and Bears (Investor's Intelligence)

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